Market Behavior of Junk Bonds

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Market Behavior of Junk Bonds

High-yield bonds, also known as junk bonds, may be actively traded on the bond market. However, their market performance can be quite different from that of higher-grade bond issues.

In general, secondary market bond prices move in the opposite direction of interest rates. Whether interest rates go up or down depends on many factors, including the policy of the Federal Reserve Board.

Less influence from interest rates

However, junk bonds are less affected by interest rates than other bonds are. This is because they have higher yields and shorter maturities. Interest rates are apt to change less over a shorter period. The market behavior of junk bonds is more in tune with overall changes in the economy, such as a recession.

Junk bonds tend to act more like stocks in their market behavior than other bonds. This is because the strength of junk bonds is connected to the strength of the company that issues them. In a recession, when interest rates fall, junk bonds might also fall in value because the companies issuing them earn less and are unable to pay off their debts. A rise in company revenues is more important to the health of a junk bond than interest rates are. A strong economy means fewer defaults and more junk bonds that are successful.

Why prices are affected by the overall economy

Likewise, junk bond prices depend more on the overall health of the US economy than do higher-grade bonds. When the stock market is doing well, companies can replace debt with equity, lessening their chance of bond default and possibly increasing bond prices.

In short, while most bond investors focus on how changes in interest rates will affect the market price of their bonds, high-yield bond investors must also understand the default risk of the issuing firm. They must understand how the company’s performance and changing economic conditions impact the risk of default.